The Changing Face of Retail

Can innovation by traditional retailers overcome the disruptive force of e-commerce?
David KatzNovember 14, 2016

Scott Settersten is a retailing CFO to be envied. The company he works for, Ulta Beauty, has 907 stores and in August was on track to complete its 2016 plans to open 100 net new locations. The company’s financial “overperformance” relative to other retailers stems largely from its exclusive focus on the particularly hot category of beauty products, says Settersten. Further, the company enjoys wider profit margins than other retailers because it features “prestige” skin-care preparations and perfumes typically priced higher than mass-market brands.

Ulta may seem an anomaly in a time when many big-name brick-and-mortar retailers are being hammered by the onslaught of online competitors. The difference may be that, unlike with those companies, the beauty retailer’s consumers are more likely to sample makeup and other cosmetics in the store rather than order them directly from its website.

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16Nov_Retail_p27aIn contrast, because “of the ongoing migration of shoppers from stores to online, many retailers are making the tough choice to shutter doors,” according to a September report by RBC Capital Markets. “Accelerated store closings [are] also not helping retail traffic.”

Kohl’s, JCPenney, Dillard’s, Sears, and Macy’s have closed a total of 700 stores since 2013, according to RBC. Next year, RBC predicts, Sears Holdings could close another 50 to 60 of its Kmart stores.

Most prominently, Macy’s announced in August that it would close another 100 stores in early 2017. Many of the company’s weaker stores “don’t produce acceptable returns on investment and often don’t represent a customer shopping experience that reflects our aspirations for the Macy’s brand,” said CFO Karen Hoguet during the company’s second quarter earnings call, “and this country is over-stored given evolving customer shopping habits.”

Besides pre-recession store overdevelopment, big retailers are also dealing with an inability to keep up with customers’ surging desire to buy online. E-commerce’s share of retail sales has increased rapidly in recent years, rising to 10% in 2015 from about 5% of sales in 2010, according to a September report by Fitch Ratings. Fitch expects online sales to burgeon to the 15% to 17% range by 2020. Retail sales data from RBC Capital Markets shows a similar trajectory in the spending shift from brick-and-mortar stores to online.

Say the Fitch study’s authors: “This suggests half of retail sales growth is expected to come online, as opposed to [from] physical retail locations. Rapid online growth, particularly from value-oriented players such as, [has] pressured sales and pricing power at brick-and-mortar retailers.”

Despite the massive number of stores being shuttered, the situation in brick-and-mortar retail is hardly as bleak as it is in some other industries. “Some of the pressures on the industry we are seeing are incremental relative to the shock of changes in energy prices” affecting oil companies, says David Silverman, a senior director at Fitch specializing in retail. “There will be winners and losers in the space, rather than the overall industry losing. There continues to be growth in consumer spending and in the sale of all retail products.”

The question now for retail CFOs, though, is how to profitably align their companies with the powerful structural changes spawned by e-commerce and the changing buying habits of consumers. To accomplish that they must face a series of tough decisions in resource allocation, inventory management, pricing, and product delivery.

Closing the Seams
The headwinds hitting brick-and-mortar retailers have been gathering force for years, but significant tailwinds have mustered strength of late. Lucky retailers find themselves in a hot industry such as running shoes or auto parts or, as with Ulta, beauty products. (See “In the Zone” at the end of this story.) But for less fortunate companies, the most oft-cited key to success is finding a way to coordinate in-store selling and various e-commerce vehicles into an “omnichannel” approach. In such a strategy, a retailer deploys all the company’s sales, marketing, and distribution tools to mutually support rather than cannibalize each other.

16Nov_Retail_p27bA second frequently mentioned approach is to focus on the “customer experience,” bringing shoppers into stores and keeping them there by encouraging them to try out fascinating new gizmos, take part in classes and special events, or simply hang out for an afternoon with family and friends.

Brick-and-mortar stores are facing “a series of changes in how the customer engages with, or wants to engage with,” retailers, says Holly Etlin, a managing director at AlixPartners, a management consultancy.

Previously, when their companies were serving primarily baby boomers, the only thing retail CFOs had to worry about was how to put stores in great locations and keep them well stocked. But with many boomers retiring or nearing retirement, millennials are becoming retailers’ core customers. “They want what they want when they want it. They do not feel constrained by store hours or locations or anything else,” says Etlin, who served as interim CFO at RadioShack prior to its 2015 bankruptcy.

“A CFO has to be looking at how a retailer allocates its capital” in order to balance spending among stores, e-commerce, and customer-engagement activities, she added. In fact, the ability to close the seams among stores, e-commerce (via mobile phones, tablets, and computers), in-store kiosks, and social media with an omnichannel strategy will be a big determinant of success in retail going forward.

Indeed, technology-oriented finance chiefs like Valen Tong don’t see online and in-store shopping experiences as necessarily opposed to each other. “I am a techie myself, and I shop a lot online,” she says. “The rise of the online experience makes it much easier for the customer: You can shop online, anywhere and anytime you want,” says Tong, the CFO of Brookstone, a specialty retailer selling frequently quirky products like electronic corkscrews, headphones resembling cat’s ears, and toy drones.

Emerging from bankruptcy in 2014 after being purchased by the Chinese conglomerate Sanpower and the Chinese investment firm Sailing Capital for about $173 million, Brookstone now owns 250 U.S. stores and takes in $400 million a year in revenue. Noting that 25% of Brookstone’s business is online, Tong says that “e-commerce is our largest store.”

16Nov_Retail_p29Moving to an omnichannel approach is “a huge opportunity because we’re increasing the number of touchpoints we have with our customers,” she says. But the move will also involve big changes for the company. The growth of e-commerce in the retail industry will result in a loosening of the current glut of per capita shopping space, Tong predicts, forcing Brookstone to be more discriminating about where to place its stores. The chain will likely have to “re-pivot” to locations in high-sales areas like airports and high-traffic malls.

Adding to Inventory
Another problem brick-and-mortar retailers must handle is how to manage inventory in the face of increasingly complex consumer buying habits. The pressure to offer their products through a variety of channels has driven many companies into an “extended aisle,” also called an “endless aisle,” of inventory, says Joel Alden, a partner in the retail practice of management consultancy A.T. Kearney.

The idea involves retailers placing kiosks in stores to enable shoppers to order out-of-stock merchandise or goods not sold in the store. The product is then shipped to customers’ homes or offices.

By operating that way, retailers add a great many products to their core assortment, which means they have to hold much more inventory at distribution centers. “Often that extended aisle isn’t within the core assortment because it doesn’t move fast,” adds Alden. “It’s slow-moving inventory, so it drives up my working capital” requirements.

At traditional brick-and-mortar companies that feel pressured to keep up with online competitors, it’s easy to feel forced into misguided capital allocation decisions in this area. “There is a massive move to technology investments to support inventory, channel investments, [and] supply chain,” says Alden. “But often those changes are made at the expense of investments in the store: training of associates, tools they use to keep up with the customers,” he adds. “Those investments are often undervalued.”

Brick-and-mortar stores with an online presence also must grapple with competitive pressures to offer lower prices and free shipping. “We expect dotcom sales growth will continue to outpace our brick-and-mortar sales, and elements such as free shipping will put pressure on our gross margin as those sales become a greater portion of our mix,” J.C. Penney CFO Edward Record noted on the struggling retailer’s August earnings call.

In turn, offering free delivery and cheaper prices online can lead to “poor customer experiences,” as in-store shoppers demand the better deals they see on their mobile phones, Alden says. CFOs contemplating the issue might thus find themselves in a dilemma. If, on the one hand, a company’s rivals are offering better deals online, it’s going to lose customers if it doesn’t offer comparable prices in its stores, the consultant adds. But if the in-store retailer cuts its prices to match online sellers, that could slash its profit margin severely.

Selling the Experience
To boost store traffic and get customers to pay full prices, retailers are allocating resources to improving the quality of the customer experience. “In technology, we’re on a path to modernize our platform and increase the productivity of delivering features that will improve the customer experience,” Nordstrom CFO Michael Koppel said during the department store chain’s second quarter earnings call. Among the changes: tech solutions to support its expanded customer-loyalty program and improve its online search engine.

In a contrasting approach to making customers happy, Best Buy slated an experience catered to its edgiest gaming shoppers. Seeking to position itself as “the home of the latest in virtual reality,” the consumer tech retailer scheduled about 350 stores to open a minute after midnight on Oct. 13. By doing so gamers could get their hands on PlayStation VR, a virtual reality headset, the minute the product was released.

Ulta Beauty is also working hard to entice shoppers to its stores. “The guest experience is number one,” says CFO Settersten, whose company’s outlets feature beauty parlors and “brow bars” where customers can get their eyebrows trimmed and woven. “And it has to be fun, or you might rather stay at home and order online.”

But the best way to lure customers into stores and keep them there may have been under retailers’ noses all along. “One question I love to ask myself is: What has not really changed?” about the retail business, says Brookstone’s Tong. She sees an example of an enduringly successful mode of selling in the centuries-old, brightly lit outdoor Christmas markets in most of the major cities in Germany.

“What do you see? You see people. They enjoy the lights, they spend time with the family, they smell the great food, hear the carols. Everything is so much fun, so much more about the experience,” she says. “People cannot get that kind of experience online.”

And while the visitors to the Christmas markets are spending quality time with their families, sniffing roasting chestnuts and enjoying the music, they’re doing a whole lot of shopping. “What has not really changed is that people are still looking for quality, looking for great value, and looking for experiences that they cannot find in other places. I think that’s the future of retail,” Tong adds.

In the Zone

One big factor determining whether a company is a winner or loser in retail is simply the subsector in which it operates. For instance, while plummeting gas prices have hit energy companies hard, they’ve been a godsend for AutoZone, which reported net sales of $3.4 billion for its fourth quarter ended August 27. That’s an increase of 3.3% compared with the fourth quarter of fiscal 2015, resulting in a 6.4% jump in net income.

Speaking on AutoZone’s September earnings call, CFO Bill Giles noted that “last year gas prices decreased $0.18 per gallon during the fourth quarter, starting at $2.69 and ending at $2.51 a gallon. We continue to believe gas prices have a real impact on our customers’ ability to maintain their vehicles.” Since cheaper prices at the pump are an incentive for more road trips and thus more wear and tear on cars, consumers will come to AutoZone stores to pick up the parts they’ll increasingly need, the finance chief suggested.

Over a longer term, the “continued aging of the car population,” spurred by an increase in miles driven in the United States, has helped produce 40 consecutive quarters of double-digit growth at the auto parts retailer, added Bill Rhodes, the company’s chief executive.

16Nov_Retail_p26Another well-placed retailer is Ulta Beauty. Operating in the beauty category provides Ulta’s stores with some protection from loss of market share to online competitors, although Amazon has reportedly been making inroads in the space. The product offerings are a factor in this, since consumers are likely to want to come into the store to sample and buy luxury makeup and fragrances, perhaps after having their appetite for new offerings whetted by Ulta’s website.

In terms of e-commerce, the company’s “a little behind some major big-box guys who have been dealing more directly with the Amazon threat,” acknowledges Settersten, noting that online sales represents only about 6% of Ulta’s overall revenue. “Specialty retailers have not been involved as much [in e-commerce], so we’re playing catch-up a little bit,” he says.

One benefit of slower online development, however, is that Ulta and similar retailers can learn “from the big guys’ missteps,” the CFO observes. Thus, they can “see how some folks have over-invested in some areas where there’s no payback,” resulting in losses on the income statement, he adds. —D.M.K.

Liquidation: The End of the Road

In a retailing environment where capital allocation can mean the difference between survival and failure, a fair number of companies just haven’t been able to cut it. Indeed, failing retailers have been much more prone to slide from bankruptcy to liquidation than the rest of corporate America, according to an August Fitch study, which analyzed 30 retail bankruptcies dating from the early 2000s to the present that collectively had $10.5 billion of debt. Half of the retail bankruptcies (15 of 30 cases) were resolved as liquidations, compared with the 17% rate seen across all corporates.

16Nov_Retail_p28Retailer defaults since the early 2000s have “resulted from shifts in consumer spending toward services and experiences, increased discounter and online penetration, and declining mall traffic, all of which have created a highly competitive environment,” says Fitch. The result? “Negative comparable store sales (comps) and fixed-cost deleverage [lead] to negative cash flow, tight liquidity, and unsustainable capital structures.”

Moreover, retailers are often inhibited from continuing operations after a Chapter 11 filing due to “heightened competition yielding permanent traffic decline, an inability to improve positioning due to negative free cash flow, and a somewhat weak position in bankruptcy proceedings relative to landlords and vendors,” says Fitch.

Which retailers may be headed down that path? Fitch screened the high-yield bond and leveraged loan universe as of Aug. 31, 2016, to identify seven U.S. retailers with significant default risk within the next 12 to 24 months. Those at-risk retailers included Sears Holdings, Claire’s Stores (which has completed a debt exchange), True Religion Apparel, 99 Cents Only Stores, Nebraska Book Company, Nine West Holdings, and Rue21. —D.M.K.